WASHINGTON (Reuters) - Housing's in the tank, banks are
scared to lend, but oil is at $100 a barrel and inflation is
threatening to pick up -- what's a central banker to do?

Federal Reserve Chairman Ben Bernanke will deploy his most
reassuring bedside manner in congressional testimony on
Wednesday and Thursday to explain how the U.S. central bank,
which has already cut interest rates 2-1/4 percentage points
since mid-September, can trim them further to prevent recession
without letting inflation get out of hand.

"Near-term, the economy remains extremely vulnerable to
further contraction because business sentiment has deteriorated
further and the aggressive Fed easing to date has been
partially offset by tighter financial conditions," Deutsche
Bank economists wrote in a note to clients. "This means the Fed
is going to have to cut rates further, which is the message Mr.
Bernanke will deliver."

Financial markets place a 92 percent chance of a half-point
cut in benchmark rates at the Fed's next meeting on March 18,
as implied by short-term interest-rate futures. Bernanke's
testimony on the central bank's semiannual report on monetary
policy and the economy will be closely scrutinized for clues on
whether those bets are on the mark.

INFLATION UNEASE

Worried that financial turmoil would undercut an already
weak economy, the Fed chopped rates by three-quarters of a
point in an emergency move on January 22, just eight days
before a regularly scheduled meeting.

It lowered them by another half point when its January
29-30 meeting wrapped up -- a one-two punch that marked one of
the most aggressive easings of monetary policy in the central
bank's modern history.

At the same time, policy-makers were taking note of a rise
in prices that has taken inflation above the 'comfort zone' of
a number of Fed officials. Most, however, believed a period of
sluggish growth would draw some inflationary pressure out of
the system, minutes of the central bank's last meeting said.

Underscoring the Fed's dilemma, the Consumer Price Index,
released on Wednesday, showed a worrisome 4.3 percent rise in
prices in the 12 months through January.

While surging energy and foods costs accounted for much of
the gain, core prices, which strip out energy and food, were up
2.5 percent, the most since last March.

"Rising prices are pinching consumers at exactly the same
time that employment is slowing and the housing market is
struggling," economic consultant Carl Tannenbaum said in a
research note.

"If growth rebounds quickly after the current soft patch
(not altogether unlikely, given the amount of fiscal and
monetary stimulus in the pipeline), the Fed may find itself
having to raise rates aggressively later on this year to keep
prices under control," Tannenbaum said.

GROWTH FORECAST CUT, INFLATION RAISED

In updated economic forecasts released last week, the U.S.
central bank lowered its outlook for 2008 growth by a half
point to between 1.3 percent and 2 percent, citing the
prolonged housing slump and bottlenecks in credit markets.

However, it also raised projections for both core and
overall inflation, a recognition of the tough environment
officials face. While the central bank lowers rates to spur
growth, it would usually raise them to combat inflation.

Bernanke's commentary this week will be scoured for signs
of how the Fed plans to respond to risks to growth, financial
instability, and rising price pressures.

"We have seen deterioration on all three fronts, so the key
to the testimony will be how Bernanke perceives the Fed's next
moves in light of ultimately fighting battles on all three
fronts," Global Insight economists told clients.

While Bernanke is expected to show the Fed focused
primarily on downside risks to growth, as he did in testimony
less than two weeks ago, he is also expected to nod to the
inflation concerns some officials have begun to highlight.

Dallas Federal Reserve Bank President Richard Fisher, a
voter on the Fed's interest-rate setting committee, said on
Friday that while growth could be slower than the central bank
expects, officials needed to be vigilant on inflation risks.

"We have to be mindful of that fact that we have to create
the conditions for employment growth, at the same time be
careful that we don't stir the embers of inflation, and that
represents the horns of a dilemma recently," he said.

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